In the following article, Professor Baskin traces the evolution of corporate finance from its beginnings among the British trading companies to its modern transformation in the United States at the end of the nineteenth century. He argues that deductive theoretical analyses based on perfect capital markets cannot always explain actual historical developments, and that financial history generally has not received sufficient attention from either economic theorists or historians. Professor Baskin suggests that financial markets developed as they did largely as a result of efforts to minimize the problems created by the asymmetry of information between company insiders and potential investors.
1 The seminal paper in applying a theoretical approach to the capital structure is Modigliani, Franco and Miller, Merton H., “Cost of Capital, Corporation Finance, and the Theory of Investment,” American Economic Review 48 (June 1958): 261–97.
2 Donaldson, Gordon, Managing Corporate Wealth (New York, 1984) discusses the financial planning models used by senior executives in major U.S. corporations; these models assume that the supply of available equity is limited. In my “On the Financial Policy of Large Mature Corporations” (Ph.D. diss., Harvard University, 1985), I show that cross–sectional statistical evidence from the United States, Europe, and Japan supports the conclusion that publicly held firms attempt to fund investment with a relatively inelastic supply of equity from retained earnings. They generally avoid common stock issues, and debt becomes the primary source of additional finance.
3 Kindleberger, Charles P., A Financial History of Western Europe (London, 1984), is an exception, but he concentrates on macrofinance.
4 For example, McCloskey, Donald suggests in The Rhetoric of Economics (Madison, Wis., 1985) that limiting empirical analysis to quantitative possibilities reflects a misguided effort to emulate an idealized version of the methodology of seventeenth–century physics.
5 For recent theoretical models of the effects of asymmetric information between managers and investors, see Jensen, Michael C. and Meckling, William H., “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure,” Journal of Financial Economics 3 (1976): 305–60; Bhattacharya, S., “Imperfect Information, Dividend Policy, and ‘the Bird in the Hand’ Fallacy,” Bell Journal of Economics 10 (Spring 1979): 259–70; Myers, Stewart C. and Majluf, N. S., “Corporate Financing and Investment Decisions when Firms Have Information That Investors Do Not Have,” Journal of Financial Economics 13 (June 1984): 187–221; and Miller, M. and Rock, K., “Dividend Policy under Asymmetric Information,” Journal of Finance 40 (Sept. 1985): 1031–51.
6 Powell, Ellis T., The Evolution of the Money Market, 1st ed. (London, 1915) employs the metaphor of biological evolution to describe (in a colorful fashion) the history of finance.
7 One might claim this distinction for the medieval guilds, but trying to draw analogies to capitalist institutions from a precapitalist society seems fraught with pitfalls.
8 Scott, William Robert, The Constitution and Finance of English, Scottish and Irish Joint–Stock Companies to 1720, 3 vols. (Cambridge, England, 1910–1912), 1: 45.
9 See ibid., 442–43, and Kindleberger, Charles P., Manias, Panics, and Crashes: A History of Financial Crises (New York, 1978). This combination of high prices and numerous promotions appears to recur throughout history. New equity issues tend to occur after stock prices have risen; when prices fall to approach their equilibrium level, investors lose money, and in the aftermath of a panic it is very difficult to raise capital through stock issues. See Taggert, R. A., “A Model of Corporate Financing Decisions,” Journal of Finance 32 (Dec. 1977): 1467–84.
10 See Scott, , Joint–Stock Companies, 1: 422.
11 Hunt, Bishop Carleton, The Development of the Business Corporation in England, 1800–1867 (Cambridge, Mass., 1936), 13.
12 Smith, Adam, An Inquiry into the Nature and Causes of the Wealth of Nations (; New York, 1937), 700.
13 See, for example, Dickson, P. G. M., The Financial Revolution in England: The Development of Public Credit, 1688–1756 (New York, 1967).
14 The fairly open market for stock in London preceding the collapse of the South Sea Bubble was an extraordinary—and short–lived—situation. The debacle at the end in fact retarded the permanent establishment of such markets.
15 Municipalities borrowed throughout the Middle Ages, usually against anticipated revenues, but the markets for this debt were highly localized, especially since units of account often were not comparable from city to city.
16 Morgan, E. Victor and Thomas, William A., The London Stock Exchange: Its History and Functions, 2d ed. (New York, 1971), 16.
17 Ibid., 97; Scott, , Joint–Stock Companies, 1: 371.
18 Morgan and Thomas, London Stock Exchange, 16.
19 Circular to Bankers, 26 Feb. 1847, cited in Hunt, Development of the Business Corporation, 109–10. Note that in British parlance, the term “stock” refers to all securities and “share” to common stock only. In American usage, “stock” may be used when only common stock is meant.
20 Morgan and Thomas, London Stock Exchange, 80, 100.
21 Carosso, Vincent P., Investment Banking in America: A History (Cambridge, Mass., 1970), 1–28.
22 Ibid., 29.
23 Davis, Joseph, Essays in the Earlier History of American Corporation (Cambridge, Mass., 1917), bk. 2, p. 3, states: “to the end of the eighteenth century, however, not only had no classification of business corporations been developed, but no sharp line was drawn between these and corporations of other sorts.”
24 Quotation from Evans, George Heberton Jr., British Corporation Finance, 1775–1850 (Baltimore, Md., 1936), 11. See the excellent discussion in Reed, M. C., Investment in Railways in Britain, 1820–1844 (New York, 1975), 76–98. For the American scene, see Cleveland, Frederick A. and Powell, Fred Wilbur, Railroad Promotion and Capitalization in the United States (New York, 1909).
25 Cleveland and Powell, Railroad Promotion, 201; Reed, Investment in Railways in Britain, 84.
26 Chandler, Alfred D. Jr., The Visible Hand: The Managerial Revolution in American Business (Cambridge, Mass., 1977), 90.
27 Evans, George Heberton Jr., “The Early History of Preferred Stock in the United States,” American Economic Review 19 (March 1929): 43–58, documents several cases of state investment. Johnson, Arthur M. and Supple, Barry E., Boston Capitalists and Western Railroads (Cambridge, Mass., 1967), details Massachusetts's intimate involvement in financing one of the first major railroads. Also see Jenks, Leland, The Migration of British Capital to 1875 (New York, 1927), 74, and Studenski, Paul and Kroos, Herman, Financial History of the United States, 2d ed. (New York, 1963), 131.
28 Quoted in Cleveland, Frederick A. and Powell, Fred Wilbur, Railroad Finance (New York, 1912), 55.
29 The effort to create comparability probably also accounts for the widespread adherence to certain incidental conventions, such as the payment of semi–annual interest on corporate bonds.
30 Johnson and Supple, Boston Capitalists, 338.
31 See Corti, Count Egon Caesar, The Rise of the House of Rothschild, trans. Lunn, B. and B. (New York, 1928); Russell, Oland, The House of Mitsui (Boston, 1939); and Hidy, Ralph W., The House of Baring in American Trade and Finance (Cambridge, Mass., 1949).
32 Carosso, Investment Banking in America, describes practices common before the Pujo investigations in 1912. Financial syndicates apparently went to great lengths to avoid disclosure of their profits. Major agreements were often made orally, rather than in writing.
33 Quoted by Morgan and Thomas, London Stock Exchange, 107, who claim that the last assertion may be slightly exaggerated. See Evans, British Corporation Finance, 10; Hunt, Development of the Business Corporation, 108; Reed, Investment in Railways in Britain, 104; and Thomas, William A., The Provincial Stock Exchanges (London, 1973), 31.
34 Reed, Investment in Railways in Britain, provides a detailed analysis of the geographical pattern of stockholdings in early British railroads. Liverpool and Manchester businessmen did hold stock in many relatively distant ventures; this apparent anomaly will be explained below.
35 Dewing, Arthur Stone, The Financial Policy of Corporations, 2 vols. in one (; 4th ed., New York, 1941), 64. The same was true in France; see Freedeman, Charles Elton, Joint–Stock Enterprises in France, 1807–1867: From Privileged Company to Modern Corporation (Chapel Hill, N.C., 1979), 30.
36 This is a central conclusion of Reed, Investment in Railways in Britain.
37 See Jenks, Migration of British Capital.
38 Johnson and Supple, Boston Capitalists.
39 See Lyon, Hastings, Corporation Finance (New York, 1916), 50–82, and Lough, William H., Business Finance (New York, 1922), 105–6.
40 Donaldson, Gordon, Corporate Debt Capacity (Boston, Mass., 1961).
41 Lintner, John, “Distribution of Incomes of Corporations among Dividends, Retained Earnings, and Taxes,” American Economic Review 46 (May 1956): 97–113.
42 My “Financial Policy of Large Mature Corporations” reviews all of the postwar cross–sectional statistical studies of capital structure, which include data spanning five countries. The unambiguous conclusion is that the pecking order predictions are confirmed. There is always a strong negative correlation between past profitability and debt leverage, and one always observes that faster–growing firms accumulate greater debt. Moreover, profit and growth rates appear capable of explaining over half of the cross–sectional variance in capital structure (depending on the quality of the data, the care of the researcher, and varying socio–historical circumstances). The macro–economic evidence also supports the pecking order hypothesis: the quantity of funds raised by new equity issues—especially by established firms—appears to be relatively insignificant in the industrial countries. See, for example, Thomas, William A., The Finance of British Industry, 1918–1976 (London, 1978), 331.
43 Modigliani, Franco and Miller, Merton H., “Corporate Income Taxes and the Cost of Capital: A Correction,” American Economic Review 53 (June 1963): 433–42.
44 Myers, Stewart C., “The Capital Structure Puzzle,” journal of Finance 39 (July 1984): 575–92. My own analysis suggests skepticism toward all studies of risk and leverage: the relationship appears too sensitive to subtle statistical biases to draw any reliable conclusions. Slight changes in specification appear able to reverse the signs of coefficients.
45 See Kay, J. A. and King, M. A., The British Tax System, 3d ed. (New York, 1983), 162.
46 Income taxes were less (often much less) than 25 percent of tax revenue in all years before 1887. See Murray, John, Finance and Politics: A Historical Study (London, 1888), 2: Appendix K.
47 See Reed, Investment in Railways in Britain, 224–27. In addition, a number of states, such as Massachusetts, limited nominal borrowing to paid–in capital. Since much equity capital was “water”—sold below par—these statutes may not have been binding. See Ripley, William Z., Railroads: Finance and Organization (New York, 1915), 116.
48 Ripley, Finance and Organization, 139.
49 Cleveland and Powell, Railroad Promotion, 156–64.
50 Withers, Hartley, Stocks and Shares (New York, 1910), 95, 96.
51 Hunt, Development of the Business Corporation, 46–47.
52 See Josephson, Matthew, The Robber Barons (New York, 1934), for a well–known (and controversial) account of these late nineteenth–century financial manipulations.
53 Cleveland and Powell, Railroad Promotion, 50–51; Dewing, Financial Policy of Corporations, 64; Reed, Investment in Railways in Britain, 35; and Ripley, Finance and Organization, 105.
54 Cleveland and Powell, Railroad Promotion, 55–56, 53, 51.
55 Ripley, Finance and Organization, 106.
56 Madden, John J., British Investment in the United States, 1860–1880 (New York, 1985), 337.
57 Ripley, Finance and Organization, 109. Par value is a better measure than book value of the funds obtained by the sale of securities, as retained earnings are generated internally.
58 These ratios are derived from a 1908 ICC report discussed by Ripley, Finance and Organization, 63. The primary reason for the differential in inter–corporate holdings derives from government regulations. It was almost invariably necessary to incorporate a railroad in the state wherein it resided, and so interstate expansion led to holding controlling interests in several firms.
59 A similar pattern is found in the textile industry. McGouldrick, Paul F., New England Textiles in the Nineteenth Century (Cambridge, Mass., 1968), 171, states that “Net stock issues were an insignificant source of funds prior to the Civil War and minor or exceptional thereafter.…It is rather clear… that stock financing was a last resort.” However, in contrast to the railroads, internally generated retained earnings appear to have been more important. The small size of textile corporations may have limited their ability to publicly issue bonds, and short–term bank loans may have been important in financing inventories and receivables.
60 The figure by capitalization is from Ripley, Finance and Organization, 108, and by mileage from Dewing, Financial Policy of Corporations, 750; see Jenks, Migration of British Capital, 292.
61 See Evans, British Corporation Finance, 39–81; Evans, George Heberton, “Preferred Stock in the United States, 1850–1878,” American Economic Review 21 (March 1931): 56–62; and Evans, “Early History of Preferred Stock.” It is interesting that offering a guaranteed return was considered superior to selling common at a discount. Perhaps it reduced bickering over values.
62 The present eclipse of preferred stock is not attributable to any essential deficiencies in the instrument, but rather to the imposition of a discriminatory corporate tax in the United States in 1909 and in Great Britain in 1947. Preferred stock is still used extensively today among utilities, which are largely able to pass tax costs on to consumers through the regulatory process.
63 See Dewing, Arthur Stone, Corporate Promotion and Reorganizations (Cambridge, Mass., 1914), 112–64, for a history of the National Cordage failure. The firm controlled over 90 percent of U.S. rope production, but because of a combination of inefficiency and major malfeasance, it was unable to reap much from its monopoly; however, it likely made huge fortunes for its promoters, who rigged markets in its stock, falsified financial reports and, like the South Sea Company, issued new securities in order to pay high dividends. Another large scandal involved Amalgamated Copper a few years later. In an influential book, Lawson, Thomas W., Frenzied Finance (New York, 1905) provided an inside account—not necessarily disinterested—of the fraudulent practices in this flotation.
64 Bankers appear always to have relied in trade finance on liens against (often insured) cargos, even in Roman times (see Frank, Tenny, An Economic History of Rome, 2d ed. [Baltimore, Md., 1927], 289). In fact, until comparatively recent times, there was much suspicion of banks' lending outside of trade, and firms would make fictitious exchanges in order to obtain finance (see, for example, Smith, Wealth of Nations, 294).
65 This movement away from mortgage bonds must have been encouraged by the clearly illusionary value of liens on unmarketable fixed assets in the frequent railroad reorganizations. It must have been realized that ultimately all creditors rely on operating income in order to be repaid—the amount of past expenditures is irrelevant—and that the position of mortgagees was therein inherently no different than that of other investors. Dewing, Financial Policy of Corporations, 1428, notes that in early bankruptcies “the fundamental legal distinction between the shareholder and the bondholder was usually forgotten, and it became the policy and practice of reorganization committees to look at the position of junior security holders as differing among themselves only in degree and not in kind.” Early practice was to charge assessments rather than to raise funds from outsiders by new issues. Dewing cites examples in which assessments were based on willingness to pay, which had the incongruous result that senior security holders were charged more.
66 Dewing, Corporate Promotion.
67 Cleveland and Powell, Railroad Promotion, 156–64.
68 Ripley, Finance and Organization, 140.
69 Dewing, Financial Policy of Corporations, 141. Similarly, Lough writes, “it has become customary to represent the tangible assets and current earning power of corporations by bonds and preferred shares and to represent the intangible assets and expected income by common shares.” Lough, Business Finance, 75.
70 Navin, Thomas R. and Sears, Marian V., “The Rise of a Market for Industrial Securities, 1887–1902,” Business History Review 29 (June 1955): 122.
71 Hunt, Development of the Business Corporation, 129–30.
72 Ibid., 134.
73 See Reed, Investment in Railways in Britain, 76–98; and Johnson and Supple, Boston Capitalists, 35–36.
74 Evans, British Corporation Finance, quotation, 104–5; 42–43.
75 Cleveland and Powell, Railroad Promotion, 46. Today most British equity issues continue to consist mostly of rights offers; however, in the United States, public general cash offers now appear more frequent. Both the exact timing and the rationale for the change in U.S. practice are unknown, but its occurrence is consistent with the weaker ties in the United States to the traditional notion of the corporation as a partnership. As with the first imposition of the corporate tax, Americans tend to reify the corporation as a separate entity. Perhaps it was not entirely a coincidence that the “modern” theory of finance, which is based on the idea that the firm exists independently of its owners and managers, developed in the United States.
76 After 1918 in the United States, the practice evolved of assigning arbitrarily low par values to common stock, and par value fell into desuetude as a signal of valuation. Graham, Benjamin and Dodd, David L., Security Analysis, 2d ed. (New York, 1940), 379, find the first example of no–par stock issued in 1918. New York state law was changed to allow no–par issues in 1912; see Robbins, Carl B., No–Par Stock (New York, 1927).
77 See Ripley, Finance and Organization, 38.
78 See, for example, the display of dividends in Burgess, George H. and Kennedy, Miles C., Centennial History of the Pennsylvania Railroad Company, 1846–1946 (Philadelphia, Pa., 1949), 799–805. The impetus to change may have been the increased use of no–par stock.
79 Quoted in Ripley, Finance and Organization, 93. The extreme tenacity of the idea that nominal capitalization matters is illustrated by this justification for periodic stock dividends, written in 1940: “By adding the reinvested profits to stated capital (instead of to surplus), the management is placed under a direct obligation to earn money and pay dividends on these added resources. No such accountability exists with respect to the profit and loss surplus. The stock dividend procedure will serve not only as a challenge to the efficiency of the management but also as a proper test of the wisdom of reinvesting the sums involved.” From Graham and Dodd, Security Analysis, 394.
80 252 U.S. 189 (1920).
81 Evans, British Corporation Finance, 76; see also Reed, Investment in Railways in Britain, 69.
82 Cleveland and Powell, Railroad Promotion, 121.
83 Chandler, The Visible Hand, 109–19; Hawkins, David F., “The Development of Modern Financial Reporting Practices among American Manufacturing Corporations,” Business History Review 37 (Winter 1963): 135–68.
84 Hunt, Development of Business Corporations, 97.
85 Ibid., 140–42; Cleveland and Powell, Railroad Promotion, 113–15.
86 Hawkins, “Modern Financial Reporting,” quotation from 155; 149–50.
87 Edwards, James D., History of Public Accounting in the United States (East Lansing, Mich., 1960).
88 Cleveland and Powell, Railroad Promotion, 142–43.
89 Withers, Stocks and Shares, quoting Pixley, 155.
90 Ibid., 92. A persistant prejudice against common stock investment can be observed as late as 1940: “We are thus led to the question: ‘To what extent is common–stock analysis a truly valid exercise, and to what extent is it an empty but indispensable ceremony attending the wagering of money on the future of business and the stock market?’ We shall ultimately find the answer to run somewhat as follows: ‘As far as the typical common stock is concerned—an issue picked at random from the list—an analysis, however elaborate, is unlikely to yield a dependable conclusion as to its attractiveness or real value. But in individual cases the exhibit may be such as to permit reasonably confident conclusions to be drawn from the process of analysis.’” Graham and Dodd, Security Analysis, 344–45.
91 Estimates by Hawkins, “Modern Financial Reporting,” 145.
92 Graham and Dodd, Security Analysis, 372. Withers, Stocks and Shares, 158, describes British practice: “Unfortunately, the amount of dividend paid by a company is too often taken as the only test of its welfare, and since dividends and depreciation are the two chief competitors for the balance of net profits, the temptation to pamper dividends at the expense of depreciation is a powerful influence on the side of bad finance.”
93 Lough, Business Finance, 440–41.
94 Jenks, Migration of British Capital, 187.
95 Evans, British Corporation Finance, 108. One cause of cost overruns was poor supervision and control in what were new organizational forms, as noted by Powell, Evolution of the Money Market, 360; Lough, Business Finance, 438. Payouts apparently remained relatively stable until the Second World War, and then declined precipitously until, by 1956, only one–third of earnings were distributed. Hart, P. E., Studies in Profit, Business Savings and Investment in the United Kingdom, 1920–1962 (London, 1965), derives estimates of retained earnings after 1920. Prais, S. J., “Dividend Policy and Income Appropriation,” in Studies in Company Finance, ed. Tew, Brian and Henderson, R. F. (Cambridge, England, 1959), 26–49, discusses the decline in payouts after the Second World War. British payouts increased slightly in the early 1960s, but declined again after 1966. See Thomas, Finance of British Industry, 221.
96 Graham and Dodd, Security Analysis, 379.
97 Ripley, Finance and Organization, 244.
98 Burgess and Kennedy, Centennial History, 441.
99 See the discussion in Navin and Sears, “Rise of a Market for Industrial Securities,” 109–10.
100 Dewing, Corporate Promotion, 550.
101 Withers, Stocks and Shares, 99. The author goes on to “mark the contrast with private firms” (p. 157). Consistent with the idea that high payouts are associated with bolstering confidence of poorly informed investors, they vary with the size of corporations and are greatest with large public firms. Holland, Daniel M., Dividends under the Income Tax (Princeton, N.J., 1962), 49, provides a dramatic display of this fact using 1936 IRS data for the United States. I arrive at similar conclusions from regressions of individual U.S. firms from the 1960s and 1970s in “Financial Policy of Large Mature Corporations.” Recent IRS data by size classes within industries shows that this finding seems an enduring characteristic of the financial system.
102 Malkiel, Burton G.. A Random Walk Down Wall Street, 4th ed. (New York. 1985), 46–80; Josephson, Matthew, The Money Lords (New York, 1972) provides an account of financial manipulations between 1925 and 1950 that suggests little in the way of revolutionary change.
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